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EarthLink: A Dividend Cut With No Guarantee for Growth

In the following analysis, we will reevaluate a company
previously identified for the Lakshmi Capital Income portfolio
after their completion of several acquisitions.

EarthLink (
ELNK
) used to be an attractive income stock because of its fat dividend
yield of 7.5%. The company managed to keep squeezing value from
dial-up services, a market that has been declining for the past
decade. Over several months the company made a shift towards the
business services segment by acquiring DeltaCom on October 1 and
One Communications on December 20. With the second acquisition
EarthLink announced a quarterly dividend cut from $0.16 to $0.05,
justifying this by the firm's strategy to become a leader in IP
infrastructure and managed services.

The question becomes - is the potential growth due to
Earthlink's shift to business services enough to make up for the
loss in value because of the dividend cut?

ELNK Consumer Services Segment: A Lost Cause

EarthLink is recognized as the best dial-up Internet service
provider in the US, although this is not much of an accomplishment
considering that the percentage of American adults using dial-up
has plunged almost 5 times over the past four years to just 5% in
May 2010. The portion of adults using broadband increased more than
50% over the past four years and stood at 66% in May.

Dial-up Internet may still be around for another decade, mainly
because of a lack of broadband penetration in the rural areas and
the reluctance to switch by the older demographic, but it is quite
evident that dial-up will be virtually extinct beyond 2020. The US
government is making a push towards broadband adoption, with the
FCC making recommendations in February to boost broadband rates in
urban areas. Moreover, Earthlink's principal provider of narrowband
communications is Level 3 Communications (
LVLT
), a company that is rated Caa1 on Moody's and has posted negative
earnings for the past five quarters. Its stock is down 40% in 2010
and is currently trading around a dollar; it will not be surprising
to see Level 3 go bankrupt in several years.

We note that Earthlink's dial-up service customer base has been
experiencing an exponential decay for the last twelve quarters. At
this rate, EarthLink will have less than 300,000 customers using
narrowband in four years.

[Click all images to enlarge]

With the recent trend of increasing broadband usage among US
households, EarthLink has attempted to increase or at least
maintain its broadband customer base, but has completely failed. In
2006 the company launched municipal Wi-Fi in the major US
metropolitan areas. Lack of demand, insufficiently reliable
service, and change in the company's senior management brought the
projects to a halt in 2007, resulting in an $80 million loss.
EarthLink's investments into broadband over powerline ((
BPL
)) in 2006 were also unsuccessful due to potential interference
with emergency radio and insufficient speeds.

Earthlink's latest attempt to increase its presence in the
broadband consumer market is to force Comcast (CMCSA ) into line
sharing as part of its merger with NBC Universal. Earthlink even
hired FCC Chief Economist Simon J. Wilkie to produce a report
stating that the merger will be harmful to most customers. However,
there is little chance that the FCC will listen to Earthlink's
arguments over Comcast's army of 78 former government employees
lobbying for the merger.

Earthlink is just unable to compete in the high-speed Internet
market against the giants Comcast, Verizon (
VZ
), AT&T (
T
), and Time Warner (TWX). At the end of Q3 2010 these four
companies held 68% of the broadband market, while EarthLink's share
was under 1%. Furthermore, EarthLink has been steadily losing its
customers over the past eight quarters, which is not the case for
the big players:

Finally, in its latest quarterly release, EarthLink did not
mention any plans to grow its consumer Internet service business,
but rather to "reposition the company as a leading IP
infrastructure and managed services provider with long-term
strategic relevance."

ELNK Business Services: Not Efficient Enough

EarthLink made two large acquisitions of integrated
communications services providers in the past three months. The
first is DeltaCom, which serves 32,000 small and mid-sized business
customers in South-Eastern US. The second is One Communications,
which serves 113,000 small and mid-sized business customers in the
North-East, Mid-Atlantic, and Upper Mid-West. With the acquisitions
Earthlink Business will operate a fiber network spanning 28,000
miles across 27 states. Earthlink, DeltaCom, and One together
serviced 274,000 business customers at the end of Q3 2010.
EarthLink has also indicated that it plans more acquisitions of
similar type in the future.

Sounds pretty good so far, but let us look at EarthLink's
operating margins in its Consumer and Business Service units:

First, we see that during the past eight quarters EarthLink's
consumer operating margin have been mostly increasing, however this
growth will eventually stop. Considering the decreasing customer
base quarter-over-quarter, we expect declining revenues from
consumer services as well. The improving operating margins will not
be enough, and income from operations in this segment will keep
decreasing at a significant rate.

A more serious concern is the drastic drop in operating margin
in the firm's Internet business services. In Q3 2010, the margin
was just 4.7%, compared to 12.5% in Q4 2008. As a result
EarthLink's income form operations in the Business Services segment
was just 2.9% of the income from the Consumer Services segment. The
recent acquisitions of DeltaCom and One Communications better
improve this margin, otherwise EarthLink's profits will keep
declining, the company will keep losing customers, and eventually
be out of business.

If we look at DeltaCom's financial statements, there is still
some hope. The company's operating margin was 6.4% in Q3 2010, more
than 4 times the 1.5% level in Q4 2008. However, this is not that
much higher than the 4.7% for EarthLink. Like EarthLink, DeltaCom
has seen a steady decline in total revenue, although its revenue
from wholesale services has been increasing.

There is no public information about One Communication's
operating margins because it is a privately held company. However,
One was purchased for around 3.7 times adjusted EBIDTA, compared to
4.7 times adjusted EBITDA for the DeltaCom acquisition. This
suggests that One's operating margins were probably worse than
those of One Communications.

With DeltaCom's and One's management still in place after the
acquisition, it is unreasonable to expect a miracle jump in
operating margins. Despite the apparent $20M in synergies to be
realized from One's acquisitions, this will not be enough to offset
the losses in EarthLink's consumer services profits. We also do not
expect the firm's business segment revenue to keep increasing after
the acquisition.

AT&T's revenue from business solutions has been declining
quarter-over-quarter since Q4 2008. In its latest SEC filing,
Verizon reported a decline of 4.6% in small business retail access
lines, partly because of "a shift to both IP and high-speed
circuits". (Although Comcast posted a 55% increase in revenue in
this segment in Q3 2010 compared to the same quarter a year
ago).

Despite its recent acquisitions, EarthLink is still no match for
Comcast and Verizon. Comcast's fiber network spans 145,000 miles,
more than 5 times that of EarthLink. Verizon's FiOS Internet is
currently rated the best in customer satisfaction, providing the
fastest upload speeds in US. The service has gained huge
popularity, with the number of subscribers up 24% in Q3 2010
compared to the same quarter a year ago.

We do not see any innovation from EarthLink, other than buying
up troubled CLECs. Like its consumer services segment, we expect
EarthLink's business services unit to keep losing customers to
larger competitors.

ELNK Trade Recommendation:

EarthLink is hopelessly losing its consumer services subscribers
across both the narrowband and broadband markets. The company's
recent buying spree is not expected to be efficient enough to
achieve long-term business services revenue growth. As a result,
the possible increase in earnings from business services is not
enough to offset the declining profits from the consumer segment.
The company's sharp dividend cut will not result in long-term
growth and the stock will not provide long-term value. We recommend
to sell EarthLink, and have sold all positions for client
accounts.

Disclosure:
We have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours. We held ELNK as
part of our income portfolio for clients but recently sold our
entire position.

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